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February 18, 2013

Conducting Due Diligence on Reverse Convertibles

Last week we began to discuss a great income-producing investment called a reverse convertible. This week, we'll take a look at reverse convertibles’ place in a portfolio and discuss some due diligence steps to consider before investing. If you didn't read my post from last week, and you are not familiar with these investments, I urge you take a few moments and read it before proceeding.

A reverse convertible is a structured product issued by a handful of broker-dealers across the country such as J.P. Morgan, Barclays and Morgan Stanley. The reverse convertibles I have bought have been issued by Barclays and marketed through JVB Financial, in Boca Raton, Fla. where Adam Kerstetter is the VP of Advisor Sales. According to Mr. Kerstetter, who works with about 1,200 advisors across the country, the underlying stock in a reverse convertible must contain a sufficient degree of volatility. In fact, the higher the volatility, the higher the annual interest rate.

For example, last November, I bought a 12-month offering based on Amazon.com (AMZN) which carries an annual interest rate of 9.25%. More recently, I bought a three-month offering on Green Mountain Coffee (GMCR) which has a 20% annual rate. In today's record low interest rate environment, these investments are a great income-producing alternative.

The key driver with these is the stock price of the underlying company. Therefore, in my selection process, I try to select companies that have a good chance of not breaching the buffer during its term. Some of the issues I consider are:

the company's leverage (i.e.; debt to equity ratio)

its current stock price relative to the past 12 months

Its current stock price relative to its industry peers,

the events that could cause the price to move drastically.

For example, this past November I bought Pultegroup (PHM). Its debt level is low and its stock is closely tied to the housing market. Hence, although past volatility may have been high, moving forward, if the housing market is truly in recovery, then Pultegroup should do well. My primary concern is that its price doesn't cross below the buffer.

To explain, PHM has a strike price of $17.11 which was established on the close of business of Nov. 27, 2012. Moreover, it has a 75% buffer. Therefore, if the price never falls below $12.83 ($17.11 x 0.75), then the client will receive his principal back at maturity, plus a 14.5% annual interest rate. As of Friday, Feb. 15, 2013, it was priced at $20.31 and has not breached the buffer. To be clear, the client will receive the interest regardless of the stock's performance. The only unknown is whether the investor will receive their original investment back or shares of the company stock. Again, please read last week's post for clarity here.

As with any investment, I would recommend a modest allocation. In fact, I would suggest less than 10% in any single offering. However, these offerings are certainly a welcome relief in this zero-interest-rate environment. I also expect interest rates will remain low until the economy begins to accelerate substantially, which may be quite some time.